Your Retirement Income Needs Are More Complicated Than You Think

Ask someone their biggest financial fear, and most of them will tell you the same thing: Running short of money in retirement. That’s why the words “retirement income” are the newest, most profitable buzzwords on Wall Street. The idea is that, since most people working today are not likely to have a traditional pension to supplement Social Security, they need to cobble together a regular retirement paycheck of their own.

Complicating matters, this income stream has to solve for three unknowns simultaneously:

Longevity: It has to last as long as you do.

Inflation: It has to keep up with the cost of living.

Health Care Needs: The cost of which has risen at a rate close to three times that of inflation in recent years.

So how do you tackle this challenge and put together a retirement income that lasts as long as you do? We gathered the latest research and put together a to-do list to take you through it.

Consider Your Consumption Habits

Are you a homebody, foodie or something else entirely? The researchers at JP Morgan found that about 75 percent of the population fits fairly into one of four spending profiles…

Foodies spend 28 percent of their income on food and drink (groceries as well as eating out).

Homebodies spend 54 percent of their income on mortgages, property taxes, renovations and things to put in those homes, like furniture and cable for the flat-screen; it’s possible some may have more than one home.

Globetrotters devote a full quarter of their income to travel.

The fourth category comprises a small group of individuals (about 2 percent of households under 65 and 6 percent over) that spends 28 percent of their money on healthcare. They may have ongoing needs for pricey prescriptions or some other chronic condition.

Consider How Your Spending Will Change

Whatever type of spender you are, though, consider that what you spend tends to change with age. The older you get, the more your expenses tend to taper off, explains Katherine Roy, Chief Retirement Strategist of JP Morgan Asset Management. That holds true even taking inflation into account. “Even though prices are increasing, you’re spending less,” says Roy. For example, the average household in the 55-to-64-year age group spends about $51,000 a year. That drops to $45,000 for 65-to-74-year-olds, and $34,000 for those people 75-plus. Category-by-category, expenses also tend to drop off as you age with the exception of charitable contributions, gifts (ah, grandchildren!), and healthcare. The latter, according to the Center for Retirement Research at Boston College, costs more than twice as much after age 85 than it does before.

Alter Your Savings Plan to Compensate

Take a look at your current spending patterns for an idea of where you might fall. Then spend some time planning your future spending in that area. For example, homebodies should look at when they are likely to be able to pay off the mortgage and/or if downsizing makes sense. “Forty-five percent of 65-year-olds still have a mortgage,” says Roy.

“Whether it’s because they’re doing an opportunity cost assessment [and investing the money instead] because they have a low interest rate, or because they pulled equity out is unclear.” If it’s the latter, planning to get out from under that loan before retirement may be a smart move. Still, the cost of selling one place, buying another, moving, and furnishing the new place shouldn’t be underestimated, says Ken Hevert, Senior Vice President of Retirement Products at Fidelity Investment. “People are often surprised by the high cost of doing these things,” he says.

Globetrotters, meanwhile, should understand that wanderlust isn’t likely to diminish as you age. In fact, spending on travel was at the highest levels for people in this profile past age 75, so it’s wise to set aside a separate bucket of money for your travels.

And as for those foodies? Although their consumption may seem off the charts, they tend to be fairly frugal in other areas, with paid-off mortgages and low property tax bills. The researchers didn’t see a need to save separately for eating out.

Separately Account for Healthcare

Fidelity Investments estimates that a 65-year-old couple entering retirement will need $260,000 (in today’s dollars) to cover healthcare costs during their lifetimes, and an additional $130,000 to insure against long-term care needs (more on this in a moment). Those are big numbers, so you’ll be well served to understand the annual costs. Last year, for instance, a 65-year-old going on traditional Medicare had an average health care spending of $4,660, a number that is rising by about 6 percent a year. Consider a separate stash of money – perhaps in a Health Savings Account – to account for these needs. “We know that individuals who have it as a [separate] line item feel much more confident they can afford these costs,” says Roy.

Strategize to Deal With Taxes

The other big eye-opener unearthed by Fidelity’s Journey Into Retirement Study: Taxes. Pre-retirement, most people have taxes withheld from their paychecks. Then they file a return, maybe get a refund, maybe make a payment and move onto the following year. Post-retirement — because the majority of retirement income isn’t taxed — taxes become an expense to be managed. To solve that problem, Hebert says, do three things:

Plan for the fact that you’re going to have to pay taxes, likely quarterly, by siphoning off money to do that job before you spend it. Fidelity withholds taxes from IRA distributions at a rate beginning at 10 percent, but allows you to increase that withholding if you choose to.

Think about whether your tax rate is going to be higher in retirement than it is now. If so, consider putting some money into a Roth IRA (or Roth 401(k)) either via contributions or conversion.

Come up with a strategy for which buckets you’re going to pull money from in retirement. In general, Hevert notes, first drawing down money on which you’ve already paid taxes is the way to go.

Plan for the Small “What-Ifs”

What happens to your emergency cushion after retirement? The advice used to be to move it into your cash account – the one you use to pay the monthly bills. The trouble is that that may not give you enough flexibility to handle unexpected bills like car repair, emergency surgery, and so on. “Increasingly, we think [maintaining] that emergency reserve fund is the right solution,” says Roy.

So how big should your emergency fund be in retirement? During your working life the rule of thumb is to have a fund accounting for 3-6 months of expenses, but there’s no equivalent rule for retirees. Instead, stop to consider how much you’d need to get you through most unexpected emergencies, and keep that amount in funds both separate and liquid. If and when you use the money — when you’re replenishing your cash account and rebalancing — be sure to replace it, as well.

Plan for Long-Term Expenses

“For most of those who do end up in a nursing home for an extended period of time [the financial ramifications] will be catastrophic,” says Jack Vanderhei, Research Director of the Employee Benefits Research Institute. Unless you have millions of dollars in investable assets, paying these costs out of pocket will be impossible; that’s why Fidelity’s model suggests insuring against them. Vanderhei suggests a Qualified Longevity Annuity Contract, or QLAC (say “q-lack”). These are deferred annuities you buy from within an IRA or other qualified retirement plan. You can put up to $125,000 or 25 percent of your balance into a QLAC (whichever is less) and that amount is excluded from minimum distribution requirements. That lowers your tax bill and protects you for the long-term simultaneously, because the income stream – which can be deferred for as long as 15 years or to age 85 – will last as long as you do.

Other retirees opt for long-term care insurance in anticipations of these expenses, though there are other options as well. The important thing is that you plan ahead for a time when you might need more care than you do now.